Five benefits of having a taxable brokerage account
By Jane Mepham
I recently had a very interesting conversation with a potential client on different types of accounts. She wasn’t sure what a brokerage account was or why she would need one, regardless of her retirement accounts.
She maximizes her retirement accounts at work, has a few savings accounts at different banks, as well as a 529 account for her children.
We ended up discussing what a brokerage account is, who can open one, the benefits of the account, what the account can be used for, and what to watch out for. The following is a high level summary of the discussion.
What is a brokerage account and who can open one?
A brokerage account is also called an investment account, a securities account or simply a taxable account.. It can be opened by anyone over the age of 18 if they have a Social Security number or Tax Identification Number (ITIN) and an address in the United States. Non-citizens and non-permanent residents can also open the account. The account can be opened with an online broker like Vanguard, or with a robo-advisor like Betterment.
Opening one of these online accounts takes very little time. Simply go to the firm’s home page and complete a new account request form. When you get started, look for companies where the account minimum is close to zero, with great customer support and access to a wide range of investment options. There are three high level investing methods.
- Online brokerage account – you are alone in the choice of investments.
- Robot-advisor – you answer a series of questions about your goals, your risk profile, etc. This allows the algorithm to design a portfolio that matches your described needs.
- A managed account – As the name suggests, even though it is a brokerage account, it is managed by a financial advisor.
A brokerage account is ideal for someone looking to learn how to invest on their own.
There are many ways to fund the account, the easiest is a direct transfer from your bank to the newly created account. Linking your bank account means you can transfer money back and forth.
You can invest in just about anything from individual stocks to mutual funds to ETFs.
The account is taxable, which means you pay taxes on any earnings or profits. If you hold the security (mutual fund, stocks, etc.) for more than a year, you pay capital gains taxes that are lower than ordinary income taxes. Capital gains tax is 0%, 15% or 20% depending on your taxable income and your reporting status.
The benefits of having a brokerage account and how to use it
- The account allows you to reap tax losses, which is one of the best ways for an investor to reduce taxes. It works like this – you sell a security that has lost value (a loss), to offset the increase in a second security that has appreciated, thus eliminating the capital gains tax.
- The same account is also essential if you are looking to take advantage of the harvest of tax gains. This strategy involves selling assets that have risen in value and then buying them back again (the 30-day wash-out sales rule does not apply here). This fundamentally increases your cost base, resulting in lower capital gains in the future. It works best during years when you are in an extremely low income tax bracket and have highly valued securities in the taxable account.
- The brokerage account is the best savings vehicle for medium to long term goals outside of retirement. It’s best to let future spending in five years (some advisors choose to go 3+ depending on what’s invested in the account) to grow in that account.
- For For example, if you are looking to save for your future health expenses while giving yourself some flexibility, this account is your best option, beyond the Health Savings Account.
- When it comes to saving for college, most families will use a 529 plan. The account grows tax-free if the money is used for qualifying education expenses. If you use the money for something else, you pay growth taxes and a 10% penalty. For families who are unsure of the 529 plan or whether they will use the money, a taxable brokerage account makes sense.
A specific example applies to families born abroad in the country, whose children do not yet have social security numbers (born abroad). There’s a good chance they’ll never be able to use the 529 plan for them. In this case, the brokerage account is the way to go.
Things to watch out for with a brokerage account
When opening the account, you have the option of making it a margin account or a cash account. A margin account allows you to borrow money from the brokerage firm to buy securities. The securities serve as collateral for the loan. Due to the potential for money loss, this option should only be used by sophisticated investors. So, avoid margin accounts and go for a cash account.
Do not invest your emergency fund here, as there is a real possibility of losing what you invest in a brokerage account.
Don’t use it as a retirement vehicle, instead use accounts like 401k, Traditional IRAs, Roth IRAs, etc. for retirement savings.
There is a special case where it may make sense to forgo traditional retirement accounts and save money in a brokerage account. If you are a foreign national living in the United States and you intend to return to your home country before retirement age and your home country does not recognize the preferential tax treatment of bank accounts retirement like the Roth IRA, then this might be your best bet to start saving for retirement.
About the Author: Jane Mepham
Jane Mepham is the Founder and Senior Advisor of Elgon Financial Advisors, an investment advisor registered in the state of Texas. She enjoys simplifying the complexities of the financial system for immigrants and the foreign born nationally.